Another great post from the Dr. today, all about credit scores. Also, can you see how tan my legs were in the picture below?? Oh, to live near the sea again.
Probably the best return on my time & energy
for free travel has come about from signing up for and at some future time
closing new credit cards. But, I think some people have fears about that and
its effect on your credit score.
Sometimes our choices related to credit
are done out of fear.
A Story
I was getting my hair did at a
stylist last week. She does a great job. Like, I won't go anywhere else in the area
anymore. We always chat about travel in the chair and she mentioned that on a
recent US Airways flight they advertised a credit card over the PA system. I
know which one, cause I have it. I've been there before too—US Air does all
this lame advertising to their captive audience during flights. But oh
well they're cheap.
Back to the story. She said she was
thinking of signing up and didn’t. Just then, someone else took a pamphlet and
signed up. She just kept telling me how they shouldn’t do that kind of thing
and ruin their credit. Since she
took a strong stance, so I didn’t respond to her comment, but I think this is
how people think.
Now I’m not saying that people SHOULD
sign up. You probably shouldn’t if you overspend, can’t responsibly pay the
bill on time, just applied for other cards, want to simplify life, or any
number of reasons—it’s a matter of being honest with yourself. But, I am saying
that if your only concern is how it will affect your credit score, then maybe
you should read on.
Your Credit Score
Your FICO credit scores are generated
only from information in your credit report. Credit reports come from the 3
credit reporting agencies: Experian, TransUnion, and Equifax. Most creditors
don’t pull all 3 reports when you request credit, but some do (notably
CapitalOne cards do). FICO is a company with a complex, proprietary scoring
algorithm. Since it’s popular, I’m sure they make lots of $ on their algorithm.
Scores range from 300-850.
Here’s a breakdown of how different
aspects of your Credit Report factor into your FICO score.
 |
| Image from MyFICO.com |
Percentage
|
What
|
Description
|
35
|
Payment History
|
Shows responsibility for paying
accounts on time
|
30
|
Amounts Owed
|
Total statement balances divide
by Total of credit limits
|
15
|
Length of History
|
Average age of accounts. Good
to keep old accounts open
|
10
|
Types of Credit
|
Real Estate, Installment Loans,
Credit Cards. Good to mix
|
10
|
New Credit
|
Inquiries impact for 1 year.
Lower impact after 1-3 mo.
|
From www.experian.com
What happens when you apply for a
credit card?
When you fill out an application online
or at a bank or online, the bank does a hard pull on your credit file. This is
called an “inquiry.” I have been able to confirm what several other points
bloggers have noted this type of inquiry does reduce your credit score by less
than 10 points (blog 1: 2-8 pts, blog 2: 3-11 pts). Technically inquiries fall
off your credit report (and hence affect your score) for only up to 1 year.
However, from my own history, it appears that the lifespan of the credit “hit”
is really 1-3 months.
If the application is approved, then
other changes will show up in your credit score. First, you have a new card
that is 0 months old. This new card will now be factored into the average age
of credit lines. This is another potential place where a credit score could be
reduced especially if you’re just starting to use your credit.
Second, your credit score will be
increased because you have a new amount added to your total credit limit, while
there is no balance on that line yet. The result is a lower credit utilization
rate. In my experience, this usually ends up increasing my credit score.
Another Story
Several years ago (probably 2006) I
opened a bank account with Key Bank because they offered a free iPod nano for
opening a new checking account and a credit card with Lock Bank (name changed
to protect the innocent). This is when iPods were the coolest possible thing. I
read the offer and it basically said I had to have $100 in the account for 6
months. So I opened the account and met the requirements. Then, I fought to get
my iPod, since they later argued that they never had such a promotion. I ended
up with the iPod. Finally, I called their service desk to close my account.
Their “retention” department told me to be careful and read me a thing about
closing accounts and warned me that it could affect my credit.
The fear built
up inside of me. “Oh no! I might ruin my credit. And I’m so young! I might
never get a home.”
With a portion of truth, it was a lie.
It was a lie to get me to keep my account open.
Like most people I didn't actually
know how credit files worked. First of all, bank accounts that are not credit
accounts are not reported to credit reporting agencies. So having a debit
card with a visa sticker on a checking account will not do anything to your credit. Secondly, although opening and closing accounts does have an
effect, the effect is very limited and most importantly, it can be understood before
closing
What happens when you close an
account?
When you close a credit card it will
only impact the last two factors—Credit utilization and average age of
accounts. Here’s how to avoid dropping your credit score when you close an
account:
Don't close your oldest accounts. If
you're not using an account, you don't necessarily need to close that account. If
you're just starting out using credit, open “no annual fee” cards so that when
you keep your oldest card open forever it won't cost you anything. Remember,
the average age is the only thing that matters here.
Credit utilization will go up when you
close an account because your total of all credit limits will go down. One
thing you can do when you close an account is to call your card company. If you
have multiple credit lines with that bank, consider moving most of the credit
line to one of your other accounts—like a no-fee card. That way your credit
utilization rate and score won’t move.
That’s it. There is no more mystery.
Now you don’t have to be afraid of opening and closing accounts.
The Rest of the Story
So I need to finish my story…
Even though I was initially afraid of
what the phone rep told me, my B.S. detector was going strong. I closed my
account with the Lock Bank. I had an iPod nano and it was awesome. Now it’s in
a box somewhere. Want it?
How my FICO score has varied
So everyone’s experience will be a bit
different. But I can speak from experience. Here’s a snapshot of my credit
score over time. (This is via creditsesame.com)
I don’t have a problem sharing this
with you. Part of the reason why we fear this credit-related items is because
it’s taboo to talk about. It is not a competition. When no one communicates,
knowledge isn’t transferred and the banks win.
What I'd point out is that all of the
stronger dips are months where I applied for 1 or 2 cards this year. The result
was minor impacts on my score and a rebound within a couple months. In
December, I closed an account and opened 2. The January score reflects that.
Note: Credit Sesame doesn't use exact FICO scoring—it’s their best guess pseudo-score and it shows trends just fine. I
think it tends to give me too high of a score compared to real FICO
scores. No matter. The point is to see the trends.
For reference here are my current FICO
scores (they come free with some credit cards)
 |
| TransUnion FICO Score from Barclays Bank |
 |
| Equifax FICO Score from CitiBank |
Thanks for another great post, Thomas! If you have any questions please leave them in the comments below and I'll have the Dr. answer them.
